Beijing faces tough choices as rising prices turn political

Wang Qishan, the Chinese vice-premier, likes to tell foreign visitors who urge a particular course of action on Beijing: “You know, we also have politics here.”

One of the defining narratives of the global financial crisis is that China’s Communist party technocrats outplayed partisan Washington and an incoherent Europe.

There is a good deal of truth in this. Beijing’s 2008 stimulus plan was earlier and more decisive than any other big economy and proved very successful at maintaining growth.

Yet as Beijing tries to come off its stimulus high, its leaders are in danger of getting hemmed in by domestic politics. Their thorny problem is rising inflation, which hit 5.1 per cent last month.

Inflation is one of the red-line political issues in China because ordinary people suffer a double whammy. Not only do living costs rise but the nearly $2,000 billion that households hold in deposit accounts start to earn negative returns. Indeed, the current round of inflation is transferring wealth from households to the big borrowers in the corporate and state sectors.

Yet politics is restraining the obvious policy responses. Despite the jump in inflation, Beijing has increased interest rates only once in the past year and by only 0.25 per cent.

One reason for the caution is that higher rates could hurt the state-owned companies that borrowed so heavily over the past two years for stimulus-related construction.

The political sensitivities are especially acute in the property sector. In many places, developers are often an extension of the local government. So if Beijing increases borrowing costs, a thunder of criticism can be expected through the party-state system.

Exchange-rate moves would offer another obvious tool to damp inflation. Yet intense backroom lobbying by China’s exporters has limited appreciation against the US dollar to little more than 3 per cent this year. Indeed, despite high growth and a still-large current-account surplus, the renminbi has actually been getting weaker against a basket of trading partners’ currencies recently.

The crucial question is: how stubborn is the present bout of inflation? It is certainly possible that inflation will peak soon and gradually subside next year. The main driver has been food prices, particularly vegetables, which were affected by bad summer weather. If it is only a short-term supply problem, inflation will ease with the next harvest.

Yet even if this current rise in prices is short lived, there are plenty of reasons to be fearful that higher inflation lurks ahead. Factory wages appear to be rising faster than before. Some economists think the huge overcapacity in industry that held back prices over the past decade is much lower today.

In addition, there is the potential impact from the ocean of new credit in the economy. Loans doubled last year and money supply has risen by about 50 per cent over the past two years. Informal lending also seems to be growing.

Fitch, the rating agency, has calculated that new credit outside the formal banking system has been Rmb3,000bn ($450bn) this year – more than a quarter of the total. “Lending has not moderated; it has merely found new channels,” said Fitch.

Given China’s impressive economic record, it may seem unfair that investors talk of the “Wen Jiabao put” – the idea that the premier will always boost lending whenever growth slows below 8 per cent, just as Alan Greenspan provided a backstop for the US stock market.

With two years left in office for Mr Wen, however, the natural tendency might be to put off tough political decisions for the next generation. Plenty of Chinese officials are lobbying Mr Wen for another year of generous lending in 2011 to keep growth humming. While Beijing has stepped up the rhetoric on structural reforms to boost consumption, few signs of substance have been noted.

If inflation subsides, China can continue to muddle along, allowing just enough lending to sustain strong growth. But a persistent rise in prices will leave Mr Wen unable to avoid some hard choices: between slower growth or higher inflation and a potentially destabilising bubble; between negative real rates or higher nominal rates; and between exporters and households. At that point, the politics of China’s response to the crisis will start to get interesting.